CBO Report Looks At US Pass-Through Income Tax Reform

by Mike Godfrey, Tax-News.com, Washington

11 December 2012

A report from the Congressional Budget Office (CBO), on the growth of taxing
United States pass-through businesses through the individual income tax code,
has examined the effect it has had on federal revenues, and the potential effects
on those revenues of various alternative approaches to business tax reform.

The CBO points out that, over the past 30 years, the activity of businesses
that are subject to the individual income tax has grown compared with that of
businesses subject to the corporate income tax. That shift has reduced federal
revenues, but probably promoted overall investment and a more efficient allocation
of resources.

Therefore, it adds, while most business receipts have come from a relatively
small number of C corporations subject to the corporate income tax (because
they are larger), the use of other organizational forms allowing businesses
to pass their profits through to their owners where they are subject to the
individual income tax has grown, such that in 1980 they represented 83% of firms
and accounted for 14% of business receipts, but by 2007 those shares had increased
to 94% and 38%, respectively.

Organizational forms, such as S corporations (those organized under the rules
of subchapter S of the Internal Revenue Code) and limited liability companies
(LLCs), that provide owners with the same protection from liability for the
debts of the firm that the owners of C corporations receive, were almost entirely
responsible for that growth.

The CBO further demonstrates that the shift in the popularity of those business
forms has also been encouraged by changes in the tax code - particularly the
enactment of the Tax Reform Act of 1986, which lowered the top marginal rate
in the individual income tax to below the top marginal rate in the corporate
income tax; and by the trend in the US away from manufacturing and towards the
services sector that derives fewer benefits from the C-corporation structure.

The CBO confirms that the growth of the newer types of businesses not subject
to the corporate income tax has significantly reduced federal revenues relative
to what would otherwise have occurred. In fact, the CBO estimates that if the
C-corporation tax rules had applied to S corporations and LLCs in 2007, and
if there had been no behavioural responses to that difference in tax treatment,
federal revenues in that year would have been about USD76bn higher.

However, it concludes that the trend toward pass-through entities’ accounting
has probably, by reducing the overall effective tax rate on businesses’
investments, encouraged firms to invest. The shift in activity toward pass-through
firms has also reduced the two biases in the current corporate income tax code
- in favour of retaining earnings rather than distributing them, and in favour
of debt financing.

To reduce the distortions caused by the current rules for taxing businesses’
income and, hopefully, increase businesses' incentives to allocate their investments
more efficiently, the CBO’s report examines three potential approaches
to the taxation of businesses' profits.

Firstly, it concludes that, while limiting the use of pass-through taxation
would increase federal revenues, this approach would probably also raise effective
tax rates on businesses’ investments and exacerbate the inefficiencies
associated with the two biases of the corporate tax code.

Secondly, integrating the individual and corporate income taxes, which includes
alternatives that achieve only partial integration, would increase the use of
pass-through taxation and have the opposite effects of the first approach. That
is, it would probably lower federal revenues, reduce effective tax rates, and
lessen the corporate tax biases.

Finally, it proposes the unification of taxes on businesses in a new entity-level
tax, which would be designed to reduce or even eliminate the two biases - particularly
the bias in favour of debt financing. Such a change could either raise or lower
revenues and effective tax rates, depending on its details.

The CBO mentions two variants of the last approach - enact a comprehensive
business income tax (CBIT), as proposed in a Treasury Department report in 1992,
or establish a business enterprise income tax (BEIT).

A CBIT would subject all but the smallest firms to an entity-level tax. It
would not allow deductions for interest or dividends paid, and would exclude
interest, dividends and capital gains from taxable income under the individual
income tax. It would thereby eliminate both corporate tax biases.

If lawmakers used the current corporate tax rate for the entity-level tax,
this variation of the approach would increase revenues. However, a lower tax
rate could possibly present an opportunity to eliminate the bias in favour of
debt financing and raise investment, while sill increasing revenues if required.

On the other hand, a BEIT would retain partial pass-through treatment for all
businesses, including corporations. Each firm could deduct from its taxable
income a cost-of-capital allowance, equal to a percentage of its assets that
was deemed to represent a “normal” rate of return on its financial
and tangible capital. Shareholders and bondholders alike would then include
their proportionate share of that allowance in their taxable income at the individual
level, regardless of the size of any actual interest or dividend payments. The
remaining profits of each firm would then be subject to an entity-level tax.

Like the CBIT, the BEIT would eliminate the two tax biases, and could also
be designed to raise investment and increase federal revenues. However, a BEIT
would add more complexity to the tax system than would a CBIT, because it would
require a firm to compute a so-called normal rate of return to pass through
to its individual owners and to deduct from its taxable profits.

It is also suggested that a BEIT’s effects on revenues would depend on
the rate selected for the entity-level tax, but it would probably raise more
in revenues than a CBIT with the same rate because more income would be subject
to the higher individual income tax rates.

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